Description

“Unless we totally mess this up we are in a good position to produce growth and substantial distribution growth.”

Tom Karam, CEO, closing comments on Q2 2015 Earnings Call

PennTex is the best investment I have seen in the energy space in a while. I think the stock will double in the next one to two years, with minimal downside. If you’re looking for a great way to capitalize on the energy/MLP dislocation then this is it. Zero commodity exposure, 100% fee-based revenue, superb asset positioning, fantastic growth potential and a sponsor that has basically stacked the deck in PennTex’s favor. We’re talking double rainbow. https://www.youtube.com/watch?v=OQSNhk5ICTI

Memorial Resource Development (Ticker: MRD), PennTex’s primary customer, reported earnings last week. They were great. Well results are strong and 2016 production is likely to exceed guidance materially. The stock is up +20%. Meanwhile, PennTex’s stock is down 3%. I attribute the difference to the ongoing rout in the MLP space and PennTex’s limited trading liquidity. I think the underperformance will correct relatively soon. PennTex trades at a near 50% discount to peers. I think there is near 100% upside over the next 12-18 months.  

The Company

PennTex is a natural gas gathering and processing midstream MLP with assets located in the Terryville play in northern Louisiana. I like PennTex because:

• It is cheap – trading at a 6.7% yield

• It is low risk – the assets are supported by 15 year take or pay contracts that ensure 100% utilization which almost guarantee +30% distribution growth

• It will grow quickly – PennTex’s major producer, Memorial Resource Development (Ticker: MRD), will likely grow production +25% per year for the next five years. This should drive +20% long-term distribution growth for a long time  

• Incentives are remarkably well-aligned – PennTex and its primary customer are controlled by the same private equity shop. The PE sponsor owns more PTXP. Beneficial treatment of PTXP is quite obvious

• The assets are competitively advantaged – PennTex’s assets are situated on top of one of the most economic natural gas basins in the world

PennTex is controlled by Natural Gas Partners (NGP), a +$16B private equity shop based in Irving, Texas. The org chart for PennTex is below.

NGP owns the GP of PTXP, as well as 63% of the LP. PennTex has an acreage dedication from Memorial Resource Development (Ticker: MRD) that covers most of northwest Louisiana. NGP also controls MRD, by way of a 38% equity ownership stake and additional 17% voting rights for stock owned by management of WildHorse Resources, an NGP-related entity focused on acquiring and de-risking E&P assets.

The Producer

MRD is a very fast growing E&P with a large position in the Terryville gas play in northwest Louisiana. As shown in the org chart below, the company is also controlled by NGP.

The Terryville is the best gas play you’ve probably never heard of and MRD has the dominant position in the play. With names for target zones like “Deep Pink” and “Lower Red” and use of E&P terms like “drilling” and “fluids”, at a very minimum researching the play will put your analysts’ maturity to the test (a test which we’ve failed miserably). Let’s put the economics of the play in context. Over 17,000 horizontal gas wells have been drilled in the US since 2012. Of those, 47 achieved peak monthly production exceeding 21 MMcfe/d. MRD drilled 16 of these extremely prolific wells on their Terryville land. A whopping 43% of MRD’s wells are in the top 100 wells ever drilled. The economics are exceptional. At current strip gas and $50 oil, MRD’s acreage offers IRRs from 44% to +170%. With an $11-12MM well cost (that will almost certainly come down), 20 Bcfe EURs and +20 MMcfe/d initial production rate, which is almost 30% liquids, the metrics are comparable with the best Utica and Marcellus well programs. However, unlike producers in the northeast, MRD is not suffering from a >$1/Mcf negative natural gas pricing differential and the liquids are easily brought to market. MRD has significantly better realized pricing than other fast growing natural gas producers and, since they actually receive Henry Hub pricing, their production is very easily hedged. And hedge they do. MRD has almost 90% of their remaining 2015 natural gas production hedged and over 80% of 2016 gas hedged. MRD is one of the only companies we follow that has actually increased cap ex from 2014 (+20% yoy company wide, +40% in the Terryville). And they will increase capex further 25% in 2016.  

MRD is also quite unique from a liquidity perspective, something that is not readily apparent from their financials. MRD is the general partner of the Memorial Production Partners (MEMP), an E&P MLP. Even though MRD’s economic interest in MEMP is negligible and they are not on the hook for any of its liabilities, they have to consolidate its $1.75B debt load. Backing this out, MRD has only $750MM in debt, and will be at just over 1.5x 2016 EBITDA by year end. The company has $565MM in liquidity versus an expected cash flow outspend of $120M through the back half of the year as they grow production from 268 mmcfe/d to 325-365 mmcfe/d. In 2016 MRD aims to grow production by 50% and build cash.

With leading well economics and a strong liquidity position, MRD is in a great position to continue to add acreage. Since their IPO last year, MRD has increased their acreage position by 79%. The net acreage position now sits at 92,000 and will almost certainly hit 100,000 by year end. The map below depicts the area of mutual interest. Production from any wells drilled by MRD in northwest Louisiana will make its way to PennTex systems. And it will do so at very attractive economics.

PennTex will also benefit from the acreage position built by another NGP-controlled entity, WildHorse Resources. WildHorse has acquired around 100,000 acres in the play and is in the process of de-risking it before eventually selling to MRD. On the Q2 earnings call, PennTex announced that they had entered into a contract with WildHorse to process their gas and they had just started to see volumes come in.

Before we move on from the producer, I’d like to suggest that those who are interested in this idea check out MRD’s Q2 earnings call. I think there are a few comments that suggest a sizable raise in 2016 production goals. Base declines are slower than initially expected. Drill times are down 20% year to date. Rig rates are down 25%. Laterals are being drilled as long as 9,000 ft (up from 7,500). And they currently have 11 rigs working versus their guidance of 8. MRD is growing fast and should accelerate PennTex’s growth substantially from what was laid out in the S-1.

Initial Assets

Initial assets include two 200 mmcf/d processing plants and associated gathering pipelines located in Lincoln Parish, LA. The total cost of the plants and pipes is around $330MM. They should generate around $85MM in EBITDA, implying a

The first plant, the Lincoln Parish Plant, commenced operations in May 2015 and the second plant, Mt. Olive, will start up next month. The first plant is running above nameplate capacity and delivery of the second plant is a few weeks ahead of schedule. It’s still early days, but operations look good. A map of the initial assets is below:

PennTex needs to spend an additional $160MM to complete Mt. Olive. They will draw on their revolver to complete the project. Pro forma for this completion, PennTex will be levered under 2x debt to EBITDA, giving it substantial capacity to grow through most of 2016 without having to issue equity.

MRD has a 15 year minimum volume commitment of 115,000 mmcfe/d, growing to 460,000 by July 2016. If PennTex only gets these gas volumes and the NGLs that come with them then EBITDA should approximate $80-90MM and distributable cash flow per share would exceed $1.60/unit. Assuming a 1.1x coverage ratio, you’re almost guaranteed a +10% yield on today’s price. I don’t know of another investment opportunity with such a quantifiable and acceptable downside, while still offering +100% upside potential.

Growth

Management has indicated $350-400MM in near-term visible organic growth projects. This will include building out the third plant and adding substantial NGL infrastructure. The company has told us to expect that these projects will be completed by mid-2017, but again, I think we will pace faster than that. A doubling of the asset size in less than 18 months with organic cap ex built at

Growing production +20% per year will have MRD adding +150 mmcfe/d per year in total production. Add in some production from WildHorse and other third-party producers, I think it is very reasonable to assume that PennTex will build one new gas processing plant per year, as well as supporting NGL infrastructure. Thus, I am assuming a run rate of $150MM/yr in growth cap ex after the initial organic projects are completed.

Running math through our cash flow model, this is what distribution growth should look like:

I’d like to call your attention to one line in particular – the GP take. Notice how it grows from less than $5MM to over $60MM in five years, at which point the GP is receiving +30% of total cash flows. This is why NGP is so incentivized to treat PennTex favorably and grow it quickly. They are transferring cash from an entity they own less than 40% of to an entity where they will have an +85% ownership. In five years NGP’s GP could be worth nearly $2B and their LP could be worth $1B – a +20x return on their $150MM cash outlay to build the first plant. The transfer of value that occurs using the MLP structure is really something and, from time to time, outsiders get a really unique opportunity to participate. We think this is one of those times.

Valuation

There are four comps that have similar relationships to fast growing gas-weighted E&Ps – Antero Midstream (Ticker: AM), EQT Midstream (Ticker: EQM), Rice Midstream (Ticker: RMP) and CONE Midstream (Ticker: CNNX). Of note, all are located in the Marcellus and Utica.

I think AM, EQM and RMP are the best comps. CNNX prices at a discount because its primary customer, CONSOL Energy (Ticker: CNX), is a coal producer levered at +3x EBITDA and liquidity challenges may inhibit growth. Even still, it is trading at a premium to PennTex. While the growth stories of these comps are arguably lower risk because the Marcellus and Utica are more established basins, I would contend that the basis differentials that Northeast producers suffer from makes the comparison a push. Not only do Northeast producers routinely sell their gas at +50% discounts to Henry Hub, but the differentials can’t be hedged. Philosophically, I think that Northeast producers will continue to be victims of their own success and there will be limited excess return generation. They will continue to grow, but it’s not risk-free. Asset quality aside, I think the favorable treatment of PennTex makes it substantially more attractive than peers. The difference between building organic cap ex at 4-5x EBITDA and acquiring dropdown interests at 8x is really meaningful.

Using these comps and considering other investment opportunities with similar growth and risk profiles, I think PennTex should price at a 4% current yield, or around $27. This represents more than 65% upside to today’s price. I believe there is substantial potential upside from $27 once the size of the Terryville is better understood.

Management

All the senior level managers have been with PennTex since its formation in early 2014. PennTex’s CEO, Tom Karam, is a 25 year industry veteran with a great track record. He was COO of Southern Union from 1999 to 2006. He founded Delphi Midstream and sold it to Williams in 2012. I am certain he can oversee the construction and operation of a few gas processing facilities. The COO and CFO each have substantial industry experience.

Risk

The biggest risk is that the results coming out of the Terryville may not continue their strong trajectory and PennTex may not have a long-term runway of infrastructure newbuild opportunity. While I can’t fully handicap this risk, I am very comfortable introducing it to our portfolio. The wells coming online right now are the some of the most economic wells in the world. They’re really big too. With IP-30 rates averaging 20 mmcf/d and EURs exceeding 20 Bcf/d, the core of the Terryville doesn’t have to be big at all to require a few Bcf/d of gas processing capacity over the next several years.

Other Notes

Delaware Basin Gathering System

PennTex has a right of first offer on a 60 mmcf/d processing plant and NGL pipeline located in Reeves County, Texas. Sellside estimates that the assets will generate $25MM in EBITDA once they are fully operational later this year. While the asset will introduce some commodity exposure to the story, the results coming out of Reeves County are encouraging and could offer an additional growth runway. In any scenario, this asset will eventually make its way into PennTex at an accretive multiple with high return growth cap ex projects ahead of it.

Regency Volumes

MRD has legacy contracts with Regency (now Energy Transfer Partners). When the contract ends in 2017 those volumes will move to PennTex systems. Since Regency will likely have a difficult time replacing those volumes, I think it is possible that PennTex could acquire the assets for a very attractive price.

Catalyst

MRD well results likely to come out later this quarter likely to be seen as significant 'de-risking' event

Announcement that Mt Olive plant is running full

Announcement of timing for third plant and additional infrastructure investment